CYS Investments (NYSE:CYS) has been my top recommendation in the mREIT sector for the last several weeks. I started out with suggesting investors use a pair trade that was long CYS and short Orchid Island Capital (NYSE:ORC). That pair trade worked out nicely and in the conclusion I was left suggesting investors close the short and hold onto the shares of CYS because they remained too cheap.
On January 19th, I released an article based on their previous price of $6.45 stating that I was "going firmly bullish on CYS Investments".
Since then I took the opportunity to pound the drums occasionally. On February 11th, I analyzed the earnings and came out looking bullish with comments such as:
"It would appear that CYS Investments may be running around a 25-30% discount to book value, which would be larger than some of its higher-cost peers that are not positioned as effectively to deal with a 'lower for longer' interest rate cycle. Since CYS Investments has been actively buying back shares at substantial discounts, it indicates favorable performance on the combination of book value plus dividends for future periods."
I also specifically stated I was positive on CYS Investments:
"Since the end of the quarter, the interest rate developments (lower for longer) should have been better for CYS Investments than for many competitors. Despite that, the company appears to be trading at a larger discount. I can't see a good argument for the relative pricing to continue, which makes me positive on CYS Investments."
Now shares have moved up to $7.54 and the huge increase in share price cuts into my thesis. I loved CYS Investments as an investment opportunity because they were trading at a substantial discount to book value. That statement was true regardless of whether we looked at the discount to book value in isolation (discounts of 25% to 30%) or the discount relative to peers. Peers were trading around the 18% to 22% range.
Over the last weekend, I modeled the performance of the company again and used the last close price to make a strong bullish case. Unfortunately, by the time it came out the share price had moved materially which cut into the thesis.
Why Shares Rallied
In a nutshell, discounts shrank across the sector and CYS Investments was trading at a fairly large discount. However, I believe there were a couple other factors. Shares opened exceptionally strong on Tuesday and there were two institutions much larger than I that were beating on the drums. It received an upgrade from JMP Securities and the buy rating was reiterated by Wunderlich. In the occasionally illiquid market of mREITs, that can help an mREIT get a sudden boost.
Remember that LIBOR rates are not immediately available for retail investors or for publication. This is an advantage carefully crafted for the larger players, but it hasn't stopped me from nailing the calls in the mREIT sector. Thankfully the market is inefficient for long enough to allow superior analysis without instant access.
The following chart uses the latest closing prices (February 19th) and the values for MBS and LIBOR rates that were in effect at the end of February 17th:
I normally don't like to run data across different days, but the substantial price movements in the mREITs warrants new analysis.
My Latest Book Value Estimations
The following chart shows book value estimations built from the third quarter positions. I'm still waiting to have complete (or moderately complete) data from each of the mREITs before rebuilding the model. At the end of the fourth quarter BV was $.15 higher than I expected, so I've built an extra $.15 into my estimation:
I do have rapid access to MBS pricing. I can safely say MBS prices rallied substantially on the 18th and the 19th. Unless LIBOR rates fell exceptionally hard, it would be expected to create a boost to book value. Normally I would expect the mREITs to have positive duration so that decline rates would result in an increase in book value even after adjusting for the negative impact of hedges.
I'd say the 30 Year Fannie Mae 4.0 increased by about .13% of par value over the last two days. The 30 Year Fannie Mae 3.5 rallied by around .18% of par value. Note that these are both premium bonds (trading above par), so the fair value increase is slightly smaller as a percentage.
I expect CYS Investments to outperform peers, but not by a large enough margin to justify a pair trade. I think the current discount relative to peers is too large. On the other hand, shares of most mREITs have been near the top of their trading ranges and near the smallest discounts to book value. At the moment the appearance of a bullish stance on CYS is created by a bearish view on the sector. Prepayments are a substantial concern despite expectations for lower short term rates and attractive funding rates on LIBOR swaps. Ironically, CYS Investments is better positioned to deal with this scenario than peers which reinforces the idea that they should outperform.
If I were establishing a longer term thesis and planning to not revisit CYS Investments for a year, then I would be inclined to use a bullish rating. When shares were $6.45, I was pounding on the drum and declaring that the market had failed. The substantial rally validates my former thesis, but it also forces me to build a new thesis. While I like CYS Investments in the longer term context, I do believe that the rest of the sector is overpriced. Because I expect the rest of the sector to be punished on the next moment of fear, I have to conclude that CYS Investments will probably get lumped in with the rest and larger discounts will appear.
There is a legitimate argument for mREITs deserving to trade at a smaller discount to book value now because the movements in LIBOR rates creates a more attractive rate that can be locked in through swaps. There is also a legitimate argument that could be made for smaller discounts based on the Fed Funds Futures indicating fairly low probability of a rate hike. Either of those arguments could make a compelling case for the "total economic return" performance of CYS over the next year. However, the presence of high prepayment rates being indicated so far during the quarter should create a headwind to yields on assets for most mREITs and I expect quite a few will end up cutting dividends this year. I'm not convinced that CYS will need to cut. If I needed to pick one of these 5 mREITs to outperform, it would still easily be CYS.
You can put me down for that prediction as well. I'm predicting outperformance by CYS over the next 3 months. I'll measure that with "total economic return" for the first quarter of 2016 (change in BV + dividend paid) and I'll measure it with change in price + dividend paid over the next 3 months.
Based on the discounts shown by peers, fair value for CYS Investments would be in the range of $8.00 to $8.26.
Stupid Technical Analysis
New Stance: Neutral
My stance is now bordering on technical analysis because I see a great mREIT with better fundamentals and excellent management trading at a discount to peers, yet I am unable to lay out a bullish rating because I expect market failure to provide a better buying point within the next month or two. All we need is some exceptionally good labor reports to justify a rate hike, a random panic event (see January 20th), or perhaps some harsh talking from the Federal Reserve. It is an awful moment when a fundamental analyst must look at the technical factors and probability of a market failure as factors overriding the fundamentals.
I don't think I've ever hated my stance as much as I do right now.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.